What Are Interest Rates?

What are interest rates

The interest rate is the percentage amount added to the price of the asset by a lender for the use of assets expressed as a percentage of the principal. The interest rate is typically made on an annual basis, known as the Annual Percentage Rate (APR). The assets borrowed could comprise cash, household goods, or large assets such as an automobile or building. Also, interest rate is a percentage added to the savings in banks and certificates.

Sometimes the interest rates differ from one lender to another when the borrower looks qualified the lender decrease the interest rate on the loan, noting that the loan that is considered high risk will have a higher interest rate.

The interest rates generated by the bank on savings account and certificate of deposit (CD) are called APY. Savings accounts and CDs apply compounded interest (accumulative at the end of the year or a specified period).

How are interest rates calculated?

The lender usually charges interest on the principal borrowed money, as a return for the bank that could have invested the borrowed amount in funds during the loan period. Hence, the borrowing cost is the difference between original loan amount and the total money repaid at maturity. 

For instance, if a person borrowed a loan of $200,000 from the bank and the bank charges 15% interest rate on that amount, this means that the borrower will have to pay the bank : The original amount of money x percentage of interest rate= $200,000 + (15% or 15/100 x $200,000) = $200,000 + $30,000 = $230,000.

Factors that could affect interest rate:

?        The government's requests to the central bank to accomplish the government's goals

?        The price of the currency

?        The term of the investment

?        The perceived probability of the borrower

?        Supply and demand in the market

?        Sometimes political factors

How do central banks use interest rates?

Banks may set higher reserve requirements, lower money supply issuance or there is greater demand for credit to maintain inflation. People prefer to save their money in the high interest rate countries, since they receive more from the savings rate. As well, they don’t go for the loans because of the high interest rate that will enforce them to repay a huge amount after the interest rate.

In other words, when the cost of debt is high, people will be discouraged to borrow and tis would eventually slow consumer demand. Also, interest rates tend to rise with inflation.

During periods of low interest rates because borrowers have access to loans at cheap rates, economies are often stimulated. Since interest rates on savings are low, businesses and individuals are more likely to spend and buy riskier assets such as stocks.

This spending fuels the economy and provides an injection to capital markets leading to economic expansion. While governments prefer lower interest rates, they eventually lead to market disequilibrium, as demand exceeds supply causing inflation to surpass target. When inflation rises, interest rates increase.

The stock market suffers since investors would rather take advantage of the higher rates from savings than invest in the stock market with lower returns and high risk.

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